September 10, 2008
If the two biggest American mortgage banks can go bust and be bailed out by the US government, could the same happen here? When the US government intervened to save Freddie Mac and Fanny Mae on Monday, it put the world on notice. We are now in a new era where our banks are the single biggest weakness in the economy and the State (meaning the taxpayer) will be expected to save them.
The developments in America have serious implications for Ireland. If anything, our property boom was more ridiculous than that of the US. So the obvious question now is whether one of our banks might go bust. It could happen, but is it probable? We don’t know; but if it wasn’t a possibility, why has the share price of Irish banks fallen 60pc in the past year?
The reason share prices have collapsed is that investors are afraid their money will disappear. Like the rest of us, they don’t believe the banks’ management. They have lost faith in the business model and they are not going to risk their money. Internationally, some senior managers of banks have been exposed as frauds, who seemed to be totally out of touch with what was going on in the banks they were supposed to be running.
They constantly underestimated the losses they were facing and when they did finally acknowledge malpractice (well after shareholders lost their shirts), it was too late. Now no one believes anything stated by banks.
As Bill Gross, of Pimco — one of the biggest investors in the US — said recently, the question today for investors is not “return on capital”, it is “return of capital”. So if the professionals are worried about the Irish banks, shouldn’t you be too?
We are in a new epoch, where it is necessary to think the unthinkable. It is only by questioning the spin, hype and lies of vested interests that we can arrive at something close to the truth.
At the moment the vested interests are circling the wagons and dismissing any concerns about the viability of Irish banks as wild speculation. They did the same three or four years ago when a few questioned the sustainability of the housing boom. Back then, those of us who said that the housing market would collapse were ridiculed and branded traitors, extremists and unpatriotic.
It is important to appreciate that what was branded extreme last year is now mainstream. Consensus-thinking has moved dramatically. It is now commonplace to hear ‘experts’, who last year were saying that the Irish fundamentals were strong, now claiming that we are in for a protracted recession.
The lesson of the past year is that the experts actually “know nothing” and therefore, you have to trust your own instinct and analysis. It’s your money after all, and if it disappears no one will cry for you.
So with that in mind, let us analyse the Irish banks. At the moment, for some reason best known to themselves, the experts are telling us that the banks are in decent shape. Last Saturday, I mentioned the possible weakness of the banks during ‘Saturday View’ on RTE1 radio. The Minister for Finance reacted to this reasonable concern by saying such talk was “dangerous”. Now I can understand the minister’s position, but suggesting that questioning the establishment is dangerous means that we have not learnt anything. Years ago, questioning the housing mania was also described as dangerous. When the establishment tries to muzzle questioning, you know we are in three monkeys territory — hear no evil, see no evil, speak no evil.
But back in the real world, we know that the banks are tightening their belts. They are not lending. The Central Bank’s monthly figures on total lending in the economy show that bank lending has fallen off a cliff. So what are the implications of this macro trend for individual banks?
Banks work in a very simple way. Typically, for every â‚¬1m in capital they have, they can lend out â‚¬10m. The profit is the difference in the cost of capital and money they borrow to lend and the interest rate they charge. If a bank is paying 4pc for your money and charging 8pc, it is making 4pc times â‚¬10m — a gross profit of â‚¬400,000. That is a whopping 40pc return on invested capital.
Of course, they have to be able to take some losses. If they had a â‚¬500,000 loan go bad, that would have eaten up all their profits and dipped into their capital. Now they would only have â‚¬900,000 in capital. That means the bank could only make â‚¬9m in loans. Either the bank will have to raise more capital from investors or reduce its loan portfolio, in addition to writing off the bad loan.
It’s easy to see how bad loans and defaults can rapidly turn a ‘strong’ bank into a ‘weak’ one. To keep lending, the bank has to go back and ask its investors for more money. However, as share prices have been falling, investors are reticent to lend to the banks.
In tandem, as house prices fall further, and unemployment rises, the bad debts in the banks will increase exponentially.
Thus, the bank in a downturn is caught between a rapidly deteriorating balance sheet and an inability to raise money. The bank still has to pay out interest on its deposits, but if it’s not earning interest on loans because they are being reneged on, it can’t pay deposits without raising more money from shareholders.
Like so many aspects of finance, the game is a confidence trick. If that confidence evaporates, as it has done in the US, depositors naturally get worried.
To make matters worse in Ireland, we know that at the height of the boom, the Irish banks were borrowing close to 50pc of their financing needs, not from depositors like you and me, but from overseas investors.
These loans have to be paid back too. Therefore, as the economy slides, the Irish depositor is in competition with the foreign investor as to who will get their money back first. This is when the crisis becomes a reality.
Who can say that over the next two years, this will not happen in Ireland? If it happened in the US this week, only a monkey can rule out the same here.